The gold standard and the Titanic

Jose-Maria Garcia-Casado

12 July 2012

Occasionally we hear the voices of a minority with a penchant for the Austrian School of thought, questioning the current monetary system and calling for a return to the gold standard or a similar model. It is an interesting debate.

Let's remind ourselves how the gold standard works. It is a monetary system in which the money issued by central banks is backed up by gold reserves. It works in direct contrast to the current fiduciary model, in which circulating money is worth what we agree it is worth. Its value is an act of faith given that the intrinsic value of a banknote is next to nothing - whatever the paper itself is worth - and said banknote no longer corresponds to a portion of the gold held in the central bank.

What does that mean exactly? Basically, it means that under the gold standard, a country was not able to place in circulation more banknotes than the number corresponding to its gold reserves. Under the current system, however, a country's central bank can print as many banknotes as it ‘wants’.

Hence, what we are debating here is basically whether we want to grant states, or rather politicians, the authority to manipulate their economy’s money supply at will. To illustrate what this means, let's take a look at some of the landmarks in the history of the gold standard.

The gold standard was first launched in 1820 by Great Britain, and fell into general use over the course of the nineteenth century, remaining in force, except for the odd interruption, until 1914, when it was suspended as a result of World War I and governments' need to fund greater levels of public spending.

After World War II, with the signing of Bretton Woods, a model similar to that of the Gold Standard was introduced. It lasted for almost thirty years, a long period of stability during which international trade and economic growth flourished. Why, therefore, was it subsequently suspended again? In 1971, under the presidency of Nixon in the US, the system was destroyed as a consequence of general imbalances triggered by overspending by the US to finance the Vietnam War. And that is how things have been right up to the present day, as we continue to function under a fiduciary system.

The fact that breaks with the gold standard have coincided with major wars is worth noting. When governments needed money to finance a war and were not capable of funding it through their income, they opted for a unilateral break with the system in place at the time and proceeded to print banknotes with no restriction. In other words, they got rid of the gold standard system whenever they wanted to spend more than they had.

One of the typical arguments in favour of the fiduciary system vis à vis the gold standard is that it permits governments to ‘play’ with the money supply to mitigate the effects of a crisis, as in the Great Depression or the current situation, the idea being that a greater number of banknotes in circulation will stimulate the economy in the short term. It is worth noting that this mechanism can also be highly destructive. If the money supply rises too high, as occurred between 2000 and 2007, it generates an inevitable cycle of asset inflation, bubble, financial crisis, and finally, economic crisis. Sound familiar?

The strange (or rather perverse) thing about this cycle is that when the crisis arrives some voices strengthen their arguments in favour of resorting once again to the Keynesian policies of liquidity injection by the state, currently a hot topic, in order to exit a crisis that was originally caused by those same policies, and so the cycle starts all over again.

Managing the money supply with precision is practically impossible, because it is like an enormous ship that is slow to turn. The moment you realise that you have steered too far to one side, the iceberg is bang in front of you and there is not enough time to react. Hence, there is a tendency to veer too far back in the other direction, which also has consequences, only this time it is the opposite effect.

The mini crisis of 2001 is a prime example. In the face of an ‘iceberg’ in the form of a possible economic crisis, Alan Greenspan's Fed initiated a low interest rate policy, veering too far the other way in an effort to avoid the original problem. His action effectively mitigated the effect, or rather postponed it, because in 2007 an enormous credit bubble burst, the result of years of excessively expansive policies, and we know all too well what happened.

History demonstrates that letting politicians manipulate the money supply does far greater harm than the problem it was supposed to solve. Why does this happen? Mainly because the argument that we can modulate the money supply to soften economic cycles is based on two incorrect premises.

The first of these is that it is possible to forecast economic cycles and adjust monetary policy accordingly and precisely. In practice, this is technically impossible. The result of trying to mitigate the effects is further distortion which only serves to actually amplify the effects we are attempting to calm.

The second premise is the good faith, independence and technical expertise of governments, central banks, and politicians. Big assumption! What happens in practice is that short-term party interests – e.g. elections - tend to come into play, if not incompetence or lack of rigour on the part of certain governors. The sum of these ingredients, technical difficulties and lack of political rigour, is disaster.

Is the gold standard the solution to these problems? The gold standard has limitations and may not be the perfect or definitive solution, but it is essential to move towards an assimilated system where money supply is not so exposed to politicians' discretion.

This would temper the economic distortions that result from monetary policy and would enable greater long-term economic stability, helping prevent bubbles like that of 2002-07, and the need for dramatic cutbacks like those we are seeing today. Better to sail more slowly, but in a straight line.